Cut the Spread
6 January 2002
In less than four months' time, clients will be free to negotiate brokerage rates with their brokers, as the 0.25% minimum brokerage will be scrapped. Last ditch efforts by anti-competitive brokers to delay that appear to have failed. So now it is time to turn attention towards another inefficiency of the Hong Kong market - the ridiculously wide spread table which determines the minimum gap between the bid and offer prices in the market.
Our order driven system
Hong Kong has an "order-driven" system, which means that buyers and sellers submit "bids" and "offers", through their brokers, directly to the market. Order driven markets are a good thing, because they offer transparency to end-users. The alternative is a "market-maker" system where only brokers can make bids and offers.
If you are a buyer, and nobody is offering stock, then all you can do is make a bid. If there are sellers making "offers" of stock, then you can decide whether to take the best offer, or alternatively, you can submit a bid which is less than the best offer. In the latter case, you join a queue of people willing to buy at that price. In this way, prioritised queues are formed of bids at descending prices and offers at rising prices. In effect, an "auction" is in continuous progress, and this market function is known as "price discovery".
The spread table
Now in order to prevent people jumping an order queue by submitting a bid at only a vanishingly better price (such as $1.0000001 to overtake a bid at $1), an order-driven market must impose a "spread" table, which specifies the "tick" or minimum increase or decrease in a bid or offer. All bids or offers must be in multiples of that amount.
In Hong Kong, the minimum bid or offer on any stock is $0.01. After that, the spread table looks like this (explanation follows):
| Price from $ |
Price to $ |
Tick $ |
Min. spread % |
Max. spread % |
Aver. spread % |
|---|---|---|---|---|---|
| 0.01 | 0.25 | 0.001 | 0.40% | 10.00% | 1.36% |
| 0.25 | 0.50 | 0.005 | 0.50% | 2.00% | 1.40% |
| 0.50 | 2.00 | 0.010 | 0.50% | 2.00% | 0.93% |
| 2.00 | 5.00 | 0.025 | 0.50% | 1.25% | 0.77% |
| 5.00 | 30.00 | 0.050 | 0.17% | 1.00% | 0.36% |
| 30.00 | 50.00 | 0.100 | 0.20% | 0.33% | 0.26% |
| 50.00 | 100.00 | 0.250 | 0.25% | 0.50% | 0.35% |
| Average | 0.78% | ||||
Here's how it works. Taking the third row, we see that prices between $0.50 and $2.00 move in $0.01 ticks - so the next price above $0.50 is $0.51, a 2% spread, the "maximum spread" in our table. And the gap between $1.99 and $2.00 is about 0.50%, the "minimum spread". So a share might be $1.99 "bid" and $2.00 "offered".
To find the "average spread" for each range, we computed the simple arithmetic average of all the spreads in the range, which assumes that stock prices are evenly distributed across the price range. For example, there are 150 possible prices between $0.50 and $1.99 inclusive, and the average spread in that range is 0.93%. Taking the simple average of all ranges (and we know, the ranges are different widths) we get a figure of 0.78%. If you looked at each range based on a median price (the middle price point in each range) you'd get an average of 0.64%.
Experts will notice that we have omitted the last three ranges of the official table, which goes up to $200 (tick $0.50) then $1,000 (tick $1.00) and finally a maximum $9,995 (tick $2.50). That's because there are currently no shares in those ranges.
What this shows
We can all get excited about decreasing brokerage rates, but there are still huge inefficiencies in the market.
Suppose, for example, you want to sell a declining stock last traded at $0.26. That puts it into the spread range of $0.25-$0.50, and the spread is $0.005. Suppose the best bid is $0.255, in which case the offer cannot be less than $0.26 (half a cent higher). If you would like to offer stock at $0.259, too bad - you either must "hit the bid" accepting $0.255, or stand at the last-traded offer of $0.26, hoping a buyer will take your offer. Now there might be competing offers for the stock, and you might be a little keener to sell than other people in the "order queue" at $0.26, but the only way you can jump the queue is to accept $0.255, which is 1.54% less than you wanted to offer. So you may end up without a trade rather than accept such a low price. Then the broker gets no commission, and the market loses volume.
It is a sad fact that some investors till think that a stock which trades at a lower nominal price is "cheaper" than one which trades at a higher nominal price, because they do not understand how shares are valued. So for psychological reasons, the majority of companies by number (small caps) are quoted at less than $1 (in the highest spread ranges), while the vast majority of companies by value, that is, the blue chips, tend to occupy the higher price ranges. But even in blue chips, investors do not have narrow spreads. Take a look at the Hang Seng Index, ranked by nominal price as of Friday, 4-Jan-02:
As you can see, the average spread of 0.47% is almost twice the current minimum brokerage commission. As brokerage rates come down, this is going to look more and more obscene. Plain and simple, the spread table must be cut. In Nasdaq, the tick was cut in 1997 from one eighth to one sixteenth of a dollar, and last year, they finally left the "pieces of eight" Spanish system and decimalised, reducing the tick to just US$0.01. The NYSE has also decimalised. Their stocks typically trade in the tens of dollars, making the tick very small.
Who benefits from wide spreads?
Practically the only people who benefit from wide spreads are those brokers, investment banks and others who make markets in stocks (sometimes including controlling shareholders - why are you not surprised?). That is because they can benefit from offering a "spread" on the shares, willing to buy from you at the best bid or sell to you at the best offer, and earning a spread in the process. There will always be a portion of customers who want instant execution of their order, and the certainty of a trade, rather than joining the bid or offer queue, and these are the juicy clients who "pay" a spread for the privilege, at the expense of market efficiency.
Cut the spread - our proposal
For those brokers who don't take market-making positions, and are simply in it for the commission, well they should be in favour of anything which increases trading volume, and narrower spreads should certainly have that effect, since more trades at the marginal prices "inside" the current spreads will be matched.
We call on the Stock Exchange to cut the spread table to no more than 0.1% at any point. Currently, we understand the trading system cannot handle price increments smaller than $0.001, which is 0.1% of one dollar. So this may mean that they have to either (a) modify the system to handle hundredths of a cent, or (b) require shares to be consolidated (reverse split) so that their nominal prices are above $1.00. For example, a stock trading at $0.25 would have to make a 10:1 consolidation (every ten old shares become one consolidated share) to take its price up to $2.50.
Descending into hundredths of a cent would probably involve a lot of costly software changes for data distributors as well as the Stock Exchange, and would put us even further out of line with world norms. Therefore consolidation is a better route to go. Consolidation always brings a problem of odd lots (less than a board lot of shares), but this is a small price to pay for market efficiency, and people would have enough notice to round up or down their holdings before consolidation took effect, so as to avoid getting odd lots.
Proposal
Here is our proposed spread table:
| Price from $ |
Price to $ |
Tick $ |
Min. spread % |
Max. spread % |
|---|---|---|---|---|
| 0.01 | 1.00 | 0.001 | 0.10% | 10.00% |
| 1.00 | 2.00 | 0.001 | 0.05% | 0.10% |
| 2.00 | 5.00 | 0.002 | 0.04% | 0.10% |
| 5.00 | 10.00 | 0.005 | 0.05% | 0.10% |
| 10.00 | 20.00 | 0.01 | 0.05% | 0.10% |
| 20.00 | 50.00 | 0.02 | 0.04% | 0.10% |
| 50.00 | 100.00 | 0.05 | 0.05% | 0.10% |
As you can see, stocks with prices below $1.00 (which currently, is most of them) would have to consolidate to achieve narrower spreads. They could be given say, 3 months to achieve this, under amendments to the Listing Rules. It would be a "big bang" approach, a one-off change to improve market volume and liquidity. None of the stocks in the Hang Seng Index would be required to consolidate, as they are all already above $1.00, even PCCW!
Force consolidation
You may find it surprising to learn that the Stock Exchange has always reserved the right, in the Listing Agreement, to require companies to consolidate their stock when the price "approaches the extremity" of $0.01. They don't appear to use it much, because there are a number of companies bumping along at the $0.01 mark, below which nobody can make a bid or offer, and a single tick upwards makes a 10% change in the price. That makes trading very illiquid - brokers end up matching orders outside the system at fractional prices. The current rule is too lax, since by the time you get down to the minimum one cent, the damage to liquidity has already been done.
We need a clear and objective rule which says that if a stock trades below a threshold for more than (say) 10 consecutive days, then it must perform a consolidation within (say) six weeks, to raise its nominal price to not less than double the threshold, which will allow it to slide another 50% before the same problem arises again. That threshold must allow room for investors to achieve reasonable trading spreads while the consolidation is in progress. Under our proposed spread table, that threshold would be $1.
There's a hidden benefit to this proposal. By bringing all stocks above the $1 mark, into a closer range of nominal prices, failing companies would be easier to spot, and less educated investors would stop relying on a stock price being nominally "low" as a measure of value. In other words, if all stocks traded in similar price ranges, the gullible investors who get sucked into syndicated ramping schemes would think a little harder.
And if we don't?
A word of warning to the Stock Exchange - if you don't do something about spread tables, the market will. Quite simply, large institutional investors will increasingly migrate their trades off-market through ECNs (electronic communications networks) who are knocking on the door seeking to provide better, more efficient execution, inside the spread. That will reduce transparency of the market as a whole, and shrink your business.
© Webb-site.com, 2002
Topics in this story
Sign up for our free newsletter
Recommend Webb-site to a friend
Copyright & disclaimer, Privacy policy